The prospects of higher interest rates in the US and Europe, indicating more normal economies, should be welcomed, not feared
It should be recognised that while the rand has been on a weakening path against the US dollar since 2010, so has the euro since the second quarter of last year. This dollar strength, coupled with euro weakness, has left the rand, weighted by the share of its foreign trade conducted in different currencies, largely unchanged since early 2014. The euro has the largest weight (29.26%) in this trade weighted rand, while the generally strong Chinese yuan has a 20.54% weight and the US dollar a much lower weight of 13.77%.
Thus there has been minimal pressure on the SA inflation rate (CPI) from higher prices for imported goods. If anything, especially when the rand price of oil and other imported commodities is taken into account, the impact has been one of imported deflation rather than inflation. And the CPI would be behaving much like the PPI is (PPI inflation is now about 3%) were it not for higher taxes levied on the fuel price and higher prices for Eskom – which is also a tax on energy consumers being asked to cough up for Eskom’s operational failures.
The rand weakened significantly against all currencies in the aftermath of the Marikana mining disaster of August 2012. The rand, on its exchange rate crosses, has not recovered these losses. However, since early 2013, the rand US dollar exchange rate has very largely reflected global rather than specifically SA influences, that is US dollar strength rather than rand weakness. The rand / US dollar on a daily basis (since 2013) can be fully explained by two variables only – by the Aussie / US dollar exchange rate, which has also consistently weakened over the period, and lower mineral and metal prices. The further statistically significant influence has been the spread between long term US interest rates and their higher RSA equivalents – this reflects SA risk, or expected rand weakness. The interest rate spread also consistently adds rand / US dollar weakness (or strength when the interest spread narrows). The ability of this model to predict the daily value of the rand / US dollar since January 2013 is shown below. The fit is a very good one. Moreover, the model displays a high degree of reversion to the mean. That is to say, an under or overvalued rand according to the model has quickly reverted to its predicted value. For now, or until SA specific risks enter the equation, for better or worse, the model presents itself as a good trading model. At present the rand, after a recent recovery, appears about one per cent ahead of its predicted value.
The future strength of the US dollar against all currencies or, equivalently, the weakness of the euro, will depend on the pace of economic recovery in the US and in Europe. The pace of recovery will be revealed by the direction of short and long term interest rates. If rates in the US increase ahead of euro rates, because the US recovery becomes more robust, the dollar is likely to strengthen, and vice versa should US growth disappoint. The question then is what might these higher rates in the US and in Europe mean for emerging equity and bond markets? Clearly higher rates in the US will ordinarily mean higher long bond yields in SA and in other emerging markets. This cannot in itself be regarded as helpful for bond and also equity values in the emerging world. However faster growth in the US and Europe would translate into faster global growth, upon which emerging market economies are so dependent. This could attract capital towards emerging markets, strengthen their currencies and narrow the interest rate spread between, for example, rand-denominated bonds and US bonds of similar duration.
It is striking how emerging market equities and currencies have underperformed the US equity markets since 2011. Measured in US dollars, the benchmark MSCI Emerging Market Index and the JSE have, at best, moved sideways while the S&P 500 has stormed ahead.
The weaknesses of the global economy over the past five years have proved to be a large drag on emerging market equities. Faster global growth, accompanied by higher interest rates, can only improve the outlook for emerging market equities and perhaps their currencies. The prospect of higher interest rates in the US to accompany faster growth should be welcomed by equity owners, especially emerging market shareholders, who have had such a rough time of it in recent years. Faster global growth, led by the US, is very likely to be good news for equity investors everywhere, and especially those in emerging markets.